A Directional Strategy That Costs You Nothing If You Are Wrong
I’m a great believer in using the right tool for the job. The backspread is an amazing little tool for when you expect a potentially big price move, but at the same time realizing that there is a good chance you could be wrong, and no move whatsoever develops. One example of when it would be appropriate to use a backspread might be when a drug company is approaching a deadline for FDA approval of a new product.
A backspread is constructed by shorting a near-the-money option and buying a larger quantity of options of the same type (calls or puts), but at a farther out-of-the-money strike. A 2×1 ratio is most common. Normally, you try to select the options in such a way that the options you short bring in as much credit as the options you buy, so that the net cash flow of opening the position is nearly zero.
Since in a backspread you are net long options, the profit potential is unlimited. At the same time, the sale of a smaller number of more expensive options effectively “pays for” the options purchased, with the result that if both legs of the backspread expire worthless, it costs you nothing. The short leg of the backspread also effectively eliminates time decay as a worry.
If all that sounds too good to be true, I’ll tell you what the catch is. There is a price zone where the backspread loses money. It’s if the underlying moves in a small way in the desired direction.
I’ll illustrate using call backspread in the ever more popular QQQ options. (Note that backspreads can be constructed in puts just as well as in calls. Put backspreads behave in a mirror image fashion to call backspreads.)
Figure 1
This particular 2×1 backspread costs $5,300 to put on. (The cost of a backspread arises from the collateral requirement for a 1×1 credit spread plus the cost of the extra calls purchased.) Note that this position loses money when the QQQ is in a range from 94 to 115. However, it is very difficult to lose all your money, as the QQQ would have to finish precisely at 104 (the long leg’s strike price) on expiration day. (Contrast this with simple option buying – where it is very easy to lose all your money!)
Big profits can be made if the QQQ moves above 115. Below 94, you lose only $308 no matter how far the QQQ may fall.
Noteworthy is the outstanding risk/reward characteristic of the T+41 line (the dashed line), representing the halfway point in the life of this position. If the expected price move happens within this time frame, you’re golden. If not, you may consider closing the position at this time for just a small loss.
A Variation
By fiddling with the ratio of calls bought to calls sold, it’s easy to construct a backspread that produces a credit when you put it on. Then your purpose in using a backspread might be completely different.
See Figure 2 for a position that probably should be considered bearish, as it makes money from the current price on down, and only a really big move to the upside would bring in a profit again. It was constructed by selling five near-the-money’s and buying seven out-of-the-money’s. This $4,000 investment makes $1,000 if you’re right about the market going down, which is not bad. Your whole $4,000 may be lost right at QQQ=104 on expiration day (not likely), and again the T+41 (dashed) line looks very good and might cause you to favor an early close.
Figure 2